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The seasonal risk of mutual funds: capital gain distributions

David Peartree

Patricia Foster

Mutual funds have many virtues, and a few serious flaws. One such flaw is their propensity to bleed investment returns due to their inherent tax inefficiency. This is a problem that manifests itself seasonally — and that season is upon us. We will examine how to spot the problem and what you can do about it.

To their credit, mutual funds have much to offer investors. Since the 1980s, they have been the go-to investment vehicle for most individual investors. They are easy to trade, they provide reasonable disclosure of their holdings and, in most cases, they offer broad diversification from the first share purchased.

Unfortunately, most actively managed funds — those where the manager’s judgment determines what to buy or sell and when — also chronically underperform. The semi-annual report known as SPIVA (S&P Indices v. Active) issued by S&P Dow Jones for the past 15 and more years has put this assertion beyond dispute. Over 10- and 15-year periods, roughly 80 percent of actively managed funds underperform their relevant market benchmark.

Mutual funds underperform for various reasons that we won’t explore here, except to note that their inherent tax inefficiency is one significant facet of the underperformance problem. At the end of the day, it’s not a fund’s gross return that matters to investors, it’s the return they see after expenses and after taxes that matters.

For example, if a fund has a gross return of 8% but the fund’s annual expense ratio is 1%, then the net return of 7% is all the investor gets. And perhaps not even that. If a fund returns 8% gross and 7% net, but those returns are subject to taxes in the year they are earned, then it’s the net after-tax return that really matters. A fund’s returns can be taxable due to dividends, interest or capital gains. Our focus here is on capital gains and specifically on the capital gains from mutual funds held in a taxable account. Capital gains are not a concern with tax-deferred accounts, such as IRAs, because all taxes are deferred until funds are withdrawn.

Many investors assume that capital gains are entirely within their control and that they will only be taxed if their fund shares have increased in value and if they choose to sell. They overlook the possibility — and, in recent years, the increasing probability — that they can also be subject to capital gains because of trades made by the mutual fund itself. That is, investors can be on the hook for capital gain taxes even if they haven’t sold anything.

The problem starts with the tax structure of the investment companies that sponsor mutual funds. Under the tax code, mutual fund companies must distribute nearly all their income and realized capital gains (at least 90%) to the fund’s investors. Capital gain distributions are typically paid annually and toward the end of the year. By late October, most funds are already starting to calculate their gains and losses for the year; by November many funds will post estimates of their expected capital gain distributions. Gains are typically paid out in December, either as cash paid directly to the investor or by being reinvested in new shares in the investor’s account.

The tax impact of capital gain distributions may not be readily apparent to investors. The returns reported by a mutual fund typically do not reflect the impact of the taxes that may have to be paid by the investor. Even if the investor receives customized performance reports from his or her investment advisor, the impact of taxes typically is not shown because each investor’s tax situation can vary. The exact tax impact is only quantified when the investor’s tax return is prepared and filed the following year. Even then, how many people look at Schedule D of their Form 1040 and realize that the additional taxes paid because of capital gain distributions from their mutual fund mean that their true investment return was less than they thought it was?

In 2018, for example, many mutual funds made capital gain distributions ranging from 10-20 percent of their net asset value. The practical impact of such large distributions is that the annual after-tax returns for an investor might be 2-3 percent less than the pre-tax return reported by a fund. In a few cases, mutual funds made capital gain distributions as high as 40 percent of net asset value and, in at least one case, over 60 percent of net asset value. The resulting tax liability can make a stellar performer look mediocre or worse on a tax-adjusted basis. Even the tax impact of modest capital gain distributions can be a significant drag on investment performance over time.

Why are some mutual funds making such large distributions? One reason is that stocks have been in a bull market for the better part of a decade and most equity funds are holding highly appreciated stocks. Another is that investors as a group have been shifting away from actively managed funds and into index mutual funds and exchange-traded funds. The migration from active to index funds means that many managers are being forced to sell stocks to generate cash for those investors looking to redeem their shares. When they sell appreciated stocks, they are then forced to pass along those gains to the fund’s remaining shareholders.

An even worse scenario involves the situation of a fund that is struggling with subpar performance and is facing a crush of redemptions as investors race for the door. The remaining shareholders are doubly punished with subpar performance and a large tax bill to boot. With another strong year for stocks this year, mutual fund investors can expect more of the same for 2019. The following are some (but by no means all) of the steps investors can take to mitigate this problem.

First, don’t buy into a fund that has a large capital gain exposure, at least not in a taxable account. Funds disclose this figure in their annual reports, and you can also find this information from sources like Morningstar.

Second, beware of funds that are undergoing large outflows due to redemptions. This often happens when there is a manager change. The combination of a manager change and fund outflows often suggests that performance has been sub-par.

Third, always be looking for offsetting losses elsewhere in your portfolio. Those losses can be used to offset an unexpected distribution of gains.

Finally, be wary of using actively managed mutual funds in your taxable accounts. Stick with index mutual funds or, even better, exchange-traded funds which can be even more tax efficient. As Christine Benz, writing for Morningstar observed, “The data continue to pile up to demonstrate that the vast majority of active funds just aren’t a good bet for taxable accounts.”

Be an informed investor.

David Peartree JD, CFP® is a registered investment advisor offering fee-only investment and financial planning advice. This column is a collaborative work by Patricia Foster and David Peartree. Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This article is provided for educational purposes and does not constitute investment advice. You should consult with your own tax or investment advisor.

About Patricia Foster and David Peartree